Fed search for policy thresholds hindered by volatility

An unexpected drop in the jobless rate last month illustrates the hurdles faced by Federal Reserve officials seeking to link monetary policy to specific economic indicators.

Unemployment fell to 7.8% in September, the lowest since January 2009, from 8.1% in August, according to a Labor Department report released last week in Washington. The rate was lower than the most optimistic forecast in a Bloomberg News survey of economists. At the same time, monthly payrolls growth slowed to 114,000 from 142,000.

That report “gives you an indication of how potentially dangerous it could be” to tie policy to an indicator such as the jobless rate, said Michael Hanson, senior U.S. economist at Bank of America Corp. in New York who formerly worked for the Fed board. “You had a big fall in the unemployment rate, but you had pretty modest growth in payrolls. This is a very volatile series.”

Since August 2011, the Federal Open Market Committee has said it was likely to keep interest rates low for a specified period of time, currently mid-2015. At last month’s meeting, “many participants” said it would be better to replace the date with language describing the “economic factors” that would prompt them to raise rates, according to minutes of the gathering released last week. The minutes didn’t specify how many policy makers supported that approach.

Officials said such an approach would provide “greater clarity” about their intentions, and would allow market expectations to “adjust automatically” as fresh data on the economy becomes available.

‘Very Explicit’

“You want policy to be conditional in a very explicit way that signals to the markets what you’re looking to achieve, as opposed to the calendar date that says how long we’re going to hang around and wait,” Hanson said.

Some policy makers also said extending the time period for low rates might be misinterpreted as a downgrade of their economic outlook, according to the minutes. Still, Fed officials also said it would be “challenging” to agree on specific thresholds, given a diversity of views.

Charles Evans, the president of the Chicago Fed, has said the central bank should promise to keep rates low until the unemployment rate falls to 7 percent, so long as inflation does not breach 3 percent. Minneapolis Fed President Narayana Kocherlakota has said interest rates should stay low until unemployment falls below 5.5 percent, so long as the outlook for inflation does not breach 2.25 percent.